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When interest rates rise, investors often look to short-term bond funds as a way to protect their fixed-income assets. Because these funds only invest in securities with maturities of five years or less, they are generally not as susceptible to interest rate movements as longer duration funds.

But that doesn't mean they can't lose money, as one reader has discovered. He invested almost a million dollars in two short-term ETFs: the iShares Core Canadian Short Term Bond Index ETF (XSB-T) and the BMO Short Corporate Bond Index ETF (ZCS-T). Now he's in the red and is not happy about it.

"My research indicated that in a rising rate environment I could expect to see the funds take a market loss equal to any Bank of Canada interest-rate increase multiplied by the ETF's duration," he wrote. "So for every 1 per cent rise in interest rates I expected a market loss of 1 per cent times 2.8 (duration), which would equal a market loss of 2.8 per cent.

"Given rate increases of 0.5 per cent so far this year I would have expected a market loss of something close to 1.4 per cent (interest rate increase x duration or 0.5 x 2.8 = 1.4). In reality, the market loss is closer to 2.2 per cent as I write. The distributions are not keeping up with market loss in value.

"I understand that the above is a rule of thumb and the market price reflects many other assumptions like future rate increases as well as the market's relative confidence levels with respect to risk.

"Furthermore, I also understood that individual bonds would be immune to a capital loss if I held those bonds until maturity and the issuer didn't default. I didn't purchase individual bonds, as it was so much simpler to purchase ETFs.

"What I would like to understand is how often do the ETFs hold the bonds until maturity? If they held the individual bonds until maturity would the NAV eventually correct itself and the market price move back up as those bonds mature, thus clawing back the market loss?, our reader asks.

"My research noted that 'authorized participants' (APs) will likely remove any price discrepancies between the ETF's net asset value and market price by creating or destroying shares of the ETF at any time. Does this arbitrage effectively lock in the market loss of the ETF?

"In general, I am trying to assess whether to sell the bond funds and lock in a loss or ride it out hoping the distributions would eventually outstrip the market loss."

These questions involve the inner workings of these ETFs so I asked both Blackrock, sponsor of XSB, and BMO Global Asset Management, sponsor of ZCS, to respond.

Mark Raes, head of ETF business development at BMO Global Asset Management, disputed our reader's return estimate, saying that as of Sept. 18 the fund had a total return of 0.2 per cent for 2017. As for holding bonds to maturity, he commented: "Typically, individual bonds trade above par as a reflection of current market yields compared to when the bonds were issued. Purchasers of individual bonds would be subject to a capital loss at maturity if they purchase at a price over $100.

"ZCS holds bonds between one to five years' maturity. Bonds are sold out of the portfolio once they fall below one year to maturity. This enhances the liquidity, and yield of the portfolio, as bonds that are less than a year to maturity can be considered short-term investments.

"The investor is correct that the APs remove the arbitrage opportunity on the ETF, which means the value of the ETF will generally move with the value of the underlying bonds. The NAV and the market price of the ETF are then subject to market movement."

I received a similar response from Blackrock, which pointed out that most of the bonds in the XSB portfolio were bought at a premium to par. "As a result, the market price of these bonds (trading at premiums) will decline over time towards their par values. If held to maturity, a bond purchased today will result in coupon income over time, but a loss on the price of the bond, which when aggregated will lead to a total return equal to the yield-to-maturity of the bond when purchased.

"For example, if one purchases a bond at 105, the investor will earn coupon income over the life of the bond, but the price of the bond will approach 100 (par value) as maturity draws closer and closer. It will not, as the investor is suggesting, jump back up to 105 at maturity, but instead will be redeemed at 100. This is true whether the bond is held through an ETF, a mutual fund, or directly.

"What does happen, though, when holding a bond to maturity, is that the investor locks in a yield-to-maturity (assuming no default). Most bond index ETFs in Canada track indices which remove bonds at the one-year-to-maturity mark, and expose the investor to a periodically rebalanced diversified portfolio of bonds that reflect the current yield, coupon, duration, credit quality, sector, and maturity profile of the portion of the market tracked by the given index."

As of midday on Oct. 12, ZCS was showing a small year-to-date gain of 0.36 per cent while XSB was down 0.28 per cent. We should not expect these numbers to improve much beyond that in the next few months given the current bond market conditions.

One final thought. RBC offers a series of bond funds that hold their positions until maturity. They are called RBC Target Maturity Corporate Bond Index ETFs and they are available for the years from 2017 to 2023. As of Aug. 31, all of the funds out to 2021 were showing small year-to-date gains. These might be a better choice for our reader.

Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters.

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